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The Hidden Tax Increase

The Hidden Tax Increase

If you earn enough to be affected by New Yorkâ€™s state and city income tax hikes but believe you will escape the brunt of the increases â€” that they will fall most heavily on the ultra-rich â€” think again.

In a bid to maximize revenues, the state Legislature has expanded an obscure provision of the tax code that effectively converts the progressive income tax into a higher flat tax on all income for many households. As a result, affected New Yorkers â€” and workers commuting to jobs in the state â€” will pay hundreds or even thousands of dollars more than the Legislatureâ€™s deceptively "modest" rate increases might have led them to expect. Like the federal government and most other states, New York has a progressive income tax system. In principle, at least, this means that there are a number of taxable income brackets, progressing upward from zero, each with a corresponding tax rate. Income in the lowest bracket is taxed at the lowest rate, income in the second-lowest bracket is subject to the second-lowest rate, and so on.

When legislative leaders announced in May that they would override Governor Patakiâ€™s vetoes, imposing a "surcharge" on upper-income taxpayers, it sounded as if they were simply adding to the existing top rates in both the state and city tax codes. They were actually doing something more costly and complicated from a taxpayerâ€™s standpoint.

The Legislature created two new income tax rate brackets for 2003: taxing income between $150,000 and $500,000 at 7.5% at the state level and 4.25% at the city level; and taxing income of more than $500,000 at 7.7% at the state level and 4.45% at the city level. If these rates were applied in a standard progressive fashion, the effects on many households just above the new income thresholds would be minimal.

However, simply adding a bracket or two to the existing tax structure would not have met the Legislatureâ€™s revenue target of $1.6 billion â€” unless the top state rate was boosted to more than 8%. This would have left New York with its highest state income tax rate since 1988, further highlighting its competitive disadvantage compared with neighboring states with much lower income taxes. It also would have resulted in a much larger tax increase for a much smaller number of taxpayers â€” the roughly 90,000 New Yorkers who earn more than $500,000 a year â€” giving them more of an incentive to move elsewhere or to take steps to shelter their New York income from higher taxes.

Instead, the Legislature found a way to minimize the apparent rate hike while aiming a larger tax hike at the roughly quarter-million New York State households earning taxable incomes between $150,000 and $500,000. This was accomplished by expanding something called "benefit recapture."

Essentially, New York State denies New Yorkers in the top income tax brackets the benefits of progressive taxation. Whereas under a purely progressive scheme the first $16,000 would be taxed at 4%, the next interval at 4.5%, and so on, those with adjusted gross incomes of more than $150,000 have had all of their income taxed at the rate of 6.85%, which was the highest rate until this year. There is a "phase out" interval between $100,000 and $150,000 where the benefits of progressive taxation are phased out, or recaptured.

With the new, higher brackets the Legislature has created, it has also created an additional recapture range: one between adjusted gross incomes of $150,000 and $200,000. As shown in the accompanying chart, this means that many New Yorkers, whose incomes fall within the upper band of the cityâ€™s middle class â€” especially working couples â€” will be hit with far bigger tax bills than they might expect if they have accounted only for the rate increases and not the tricky restructuring.

In fact, many New Yorkers in the second-highest tax bracket effectively will face higher marginal rates â€” the taxes paid on the last dollar earned â€” than those in the highest tax bracket. Some of those moving from the second-highest to the highest tax bracket will face an especially enormous marginal tax rate. On the first dollar earned more than $500,000, a taxpayer will be liable for $1,000 more in state taxes and another $1,000 more in city taxes â€” constituting up to a 200,000% marginal rate on that dollar.

City residents confronting the biggest marginal effects will have a strong incentive to avoid earning enough to be hit with confiscatory tax rates. The result will be an even weaker New York economy.

Say, for example, that you are a freelance writer living with your lawyer spouse and two children in a Brooklyn brownstone apartment. Soon after Thanksgiving, you tally up your accounts and estimate that, after deductions, your family will end the calendar year with $150,000 in taxable income â€” just below the threshold of the state and city tax increase.

Itâ€™s been a good year, but living in the city is expensive, and youâ€™d still like to scrape together a few hundred more dollars for holiday gifts for family and friends. Now suppose an editor calls you with a small project for which he offers to pay $750. At last yearâ€™s tax rates, another $750 fee would have netted you $437 after federal, state, and city income taxes, making it well worth your effort to accept the assignment. But in 2003, thanks to the peculiar structure of the new state and city tax law, you will owe at least $684 on the next $750 you earn â€” an effective tax rate of 91% â€” so this project will now net you just $66.

If you donâ€™t care to effectively donate most of your next writing fee to the government, you could either contribute the fee to a tax-deductible charity or simply turn down the assignment. You could also ask the client not to pay you until after the next tax year starts on January 1, in which case it could expose you to a similar problem in 2004 if your income is otherwise the same. The more you think about it, the less interested you are in accepting the project at all.

In that case, you wonâ€™t be spending that extra cash in local stores, and the state and city will collect less in taxes than this activity would have generated under the old tax code.

The state and city income tax increases are supposed to expire after 2005. However, with both the state and city facing sizeable budget gaps over the next two years, that promise does not look credible. Perhaps the Legislature will face more pressure to lift these growth-killing taxes, however, once taxpayers realize how hard â€” and underhandedly â€” they have been hit.